All Roads Lead to Return on Capital

From a simple savings account to the most speculative startup, return on capital is at the heart of investing.

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Image from my financial/artist intern, ChatGPT.

All That Matters

From a simple savings account to the most speculative startup, return on capital is at the heart of investing.

Perhaps the foundational principle of investing is return on capital. We lay out money today expecting more money later. Let’s forget about speculative gains — the unearned kind that come from transactions among market participants (think crypto) or price multiple changes. I’m talking about earned returns from savings accounts, real estate, and operating businesses, including stocks. All are united under the banner of earning a return on the underlying capital invested in the asset.

The Plain Vanilla Savings Account Reveals A Basic Formula

It might seem odd to think of a savings account this way, but here goes. Let’s assume your local FDIC-insured bank pays interest on its savings accounts of 5%. You invest $100,000 in the account. A year later, you’ll have $5,000. Elementary, yes, but let’s unpack it in the manner of a business analyst:

• Capital invested in the enterprise is $100,000. Your balance sheet looks like this:

  • Savings account: $100,000

  • Total assets: $100,000

  • Equity: $100,000

• You have an income statement, too:

  • Revenues: $5,000

  • Expenses: $0

  • Operating income (EBIT): $5,000

A universal equation for analyzing a business is capital turnover times operating margin. Our simple savings account has these inputs as well:

• Revenues-to-capital: $5,000 / $100,000 = $0.05 or 5%

• Operating margin (EBIT margin): $5,000 / $5,000 = 100%

• Revenues/capital x operating margin: 5% x 100% = 5% return on capital

Our savings account “business” has a low turnover rate of just 5%, generating 5 cents of revenue for every dollar of capital. BUT, it also features 100% operating margins.

Real Estate

I’m not a real estate investor, but I spent plenty of time analyzing deals during my time as a banker in commercial lending. Real estate typically features relatively low capital turnover but seemingly very high margins.

A cash-financed property worth $100,000 (to use an unlikely figure but consistent with above) might have rental revenue of $10,000 per year and a net operating margin of 50%. If we were to just look at margins we might conclude that wow, this is an incredible business. But it has a relatively low and offsetting capital turnover ratio.

• Revenues-to-capital: $10,000 / $100,000 = $0.10 or 10%

• Operating margin: $5,000 / $10,000 = 50%

• Revenues/capital x operating margin: 10% x 50% = 5% return on capital

Now, real estate is typically financed with debt, but I’m going to ignore that and focus on the capital investment. Why would an investor accept the same return on a presumably risky real estate venture when they could get the same return risk-free?

The answer is growth. The example above corresponds to a cap rate of 5%, which is pretty typical in multi-family real estate now. The only reason to accept the same initial rate as a savings account is if you expect higher returns later (this will be key later).

Assuming 3% rent growth, the return on the original capital investment will increase to 5.15% in Year 2 as rents increase to $10,300 and NOI to $5,150. With the same valuation/cap rate (5%), the property will be worth $103,000. If we sold now¹, our total pre-tax return would be 8%:

• 5% from the $5,000 of net operating income

• 3% from the increase in value from $100,000 to $103,000

By choosing real estate, we’ve improved our return from 5% to 8%.

The Underlying Reality

What’s going on here is the inflation protection inherent in real estate. Leaving aside rent increases due to supply/demand imbalances, in a world of zero inflation, rents would stay flat. Investing in real estate under our scenario above would return the same 5% return as the risk-free savings account option.

This reveals the call option embedded in real estate in the form of inflation protection.

Long-lived assets like buildings and land do not need to be replaced, shielding the investor from the requirement to contribute more capital to do the same amount of business.

Growth

We only have two levers to pull if we want our savings account operating income to grow:

1. Find a higher rate of return

2. Increase our capital investment

With Option 1 off the table, the only way to grow is to retain earnings. To grow earnings to the same $5,150 as the real estate example would require capital to grow to $103,000 or 3%.

This earn-more-by-putting-up-more scenario is the investment reality for most businesses.

And it holds true with real estate. Under a zero inflation scenario where rents don’t (or can’t) increase, we’d have to find a way to invest the same $3,000 additional capital to achieve the same 3% growth rate.

The real estate example with increased earnings of 3% without putting in additional capital isn’t magic; it’s the effect of a depreciating currency.

Moving to Stocks

Most businesses have some combination of savings account and real estate attributes (even if they don’t own real estate). They require additional capital investment to grow like a savings account, and they can raise prices to counter inflation. The savings account attribute reflects the fact that returns on capital are competed to the margin under a capitalist system, and the inflation protection stems from the ability to pass along prices.

Very rare is a dream business like See’s Candies² or a payments “toll-bridge” that can increase earnings without meaningful capital investment.

But all companies can be analyzed with the framework described above:

A manager can improve return on capital by generating the same amount of earnings with lower capital investment (a higher margin), or by entering higher-margin businesses with higher capital requirements. Increasing earnings by increasing capital investment isn’t a reason to tout “record earnings” — it’s simply the math of retaining earnings. All growth isn’t necessarily equal or even desirable if it comes at an insufficient return on capital.

The Speculative Start Up

Let’s turn to the “Speculative Startup”. Again, leaving aside selling your investment at a higher price to another person, the only way to generate a satisfactory return is through our equation.

Startups are typically valued at high prices relative to current earnings (if they have earnings at all) because of future expectations. In its nascent stages, returns on capital might be very high, perhaps reflecting higher turnover AND high margins. Let’s put numbers in.

Assume we must pay $100,000 for this startup (a 3rd alternative to our savings account and real estate options above). But now, the underlying capital investment is just $1,000. In the examples above, we paid book value or 1x the underlying capital. This meant the returns from the business translated into the same return for us as the investor. Now, we’re paying 100x the underlying capital, meaning we’re only going to get 1/100th or 1% of whatever the business earns.

However, Speculative Startup, Inc. (SSI) as a business, has great attributes:

• Revenues: $1,000

• Operating income: $500 or 50%

• Invested capital: $1,000

Our revenue/capital ratio is 100%, and our margin is 50%, which means a return on capital of 50%. That’s incredible. But again, we’ve paid 100x the underlying capital, so our going-in return is only 50% / 100 = 0.50%.

Buying SSI could make sense under certain scenarios. Let’s pull out the equation again, adding the final component at the top:

INVESTOR RETURN = UNDERLYING RETURN / MULTIPLE OF CAPITAL

UNDERLYING RETURN = CAPITAL INVESTMENT x RETURN ON CAPITAL

RETURN ON CAPITAL = CAPITAL TURNOVER x MARGIN

CAPITAL TURNOVER = REVENUES / CAPITAL

MARGIN = OPERATING PROFIT / REVENUES

There’s a margin limit, and that’s 100%. This business needs reinvestment opportunities to make any sense as a viable investment candidate. Let’s say it retains 100% of earnings.

Year 2 looks like this (switching the order to think through the steps logically):

• Invested capital: $1,500 ($1,000 original plus $500 retained)

• Revenues: $1,500

• Operating income: $750 or 50%

Our return on our original investment is now $750/$100,000 = 0.75%.

So far, so good. Let’s walk through a few more years (earnings as % original investment):

Year 3: 1.13%

Year 4: 1.69%

Year 5: 2.53%

Year 6: 3.80%

Year 7: 5.70%

Year 8: 8.54%

Year 9: 12.81%

Year 10: 19.22%

It’s only until Year 8 that we start to achieve a reasonable return on our original investment, and we haven’t even considered the time value of money.

There’s a lot that has to go right to earn these kinds of returns. The business must continue to earn a high return AND it must be able to reinvest 100% of earnings into growth, producing an annual growth rate of 50% for the better part of a decade.

There’s a lot of risk in that happening in a capitalist system with competitors trying to take your business. Competition could come in, cut prices, and erode margins, simultaneously reducing capital turnover. Or maybe margins stay the same, but there’s only room for so much growth. Or management stumbles in keeping up with 50% growth. Any number of these things might happen.

The general lessons of this extreme example are that returns must come from somewhere, and growth has a cost. There is very likely no way this business could grow AND distribute earnings.

Conclusion

The way investors make money ultimately comes back to a company’s return on capital. An investor’s job is to analyze a business to understand how much capital is required to operate the business, assess normalized profit margins, and determine the opportunities for profitable growth, all while trying to work out how the factors might change in a competitive operating environment and evaluating how management is playing its hand.

Then and only then can you make an assessment of valuation and the appropriate multiple of the underlying capital to pay for the business.

By focusing on return on capital, an investor strips away the distorting effects of financing decisions and gets to the heart of opportunity and risk.

All roads lead back to return on capital.

Stay Rational!

Adam

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1. Ignoring frictional costs for you purists.

2. A topic for future discussion is that See’s must maintain an investment in intangible brand assets through outlays of advertising and marketing spend through the P&L. Bruce Greenwald opened my eyes to this reality. (It’s still a great business either way.)